A fair market value of a business is what a reasonable person/company would pay without considering any special circumstances. That is the proper way to estimate the likely sales price from a legal perspective.

However, a business owner typically wants to sell to the person or company that has the best potential to earn profits on this business. This will be a person or company that has assets that they can leverage in combination with this business to produce greater value than before – the Strategic Buyer

Consequently, a business owner should be looking for potential buyers with special circumstances that might justify a higher price than the valuation. This should be an important consideration in setting the listing price.

There can also be special circumstances that reduce the likely sales price below what the valuation shows. A motel at the edge of Death Valley may have a low vacancy rate and solid profits, but there are likely to be fewer potential buyers of motels that want to live near Death Valley, than a motel in San Diego with similar earnings potential.

Business brokers generally will tell owners that a business in an industry should sell for a multiple of the firm’s revenue. For example, landscaping businesses may sell for 1 times revenue. The multiples typically vary by industry and size of firm.

This multiple is supposed to be the median value of multiple private company transactions for companies in the same industry around the same time and excluding the impact of special circumstances, such as real estate. However, there are no “official” sources of this kind of information and so these multiples are highly anecdotal.

The biggest problem with using a revenue multiple for valuation is that leads to an equal valuation for two companies with the same revenue but different earnings. Hence, the best performing company in terms of earnings is penalized if the owner accepts the revenue multiple method of valuing the firm; while the worst performing company in terms of earnings does much better than it otherwise would.

The business broker benefits if he/she can convince both the seller and potential buyer to base their negotiations starting with this simplistic revenue to value multiple. It establishes the broker’s credibility and may speed the process along; however, it does not necessarily benefit either the seller or buyer.

Earnings-based multiples avoid the one of the problems of the revenue-based multiple, since firms with above average earnings will have a higher value than firms with below average earnings. Earnings-based multiples also suffer the same problems of uncertain degrees of comparability across firms and of timeliness.

However, the key problem with earnings multiples is that there is no consistency in how privately held companies report their earnings. There is no adjustment for the level of owner compensation or for discretionary expenses that the owner makes through the firm, as there is in a valuation.

Consequently, a business owner does not know how reliable the information is that was used to construct this multiple. We advise owners to view these numbers with skepticism, and to question the business broker about the source, comparability, and timeliness of the transactions that went into this multiple.

The central financial maxim of most established, privately held businesses is to minimize taxes. The company financials and tax returns reflect this strategy.

A key element to exit planning for most owners is how to maximize the value of the company (with the possible exception of family businesses that will stay in the family).

Maximizing the value of the business requires a significant shift in focus from tax minimization, and needs a period of transition of at least 3 years. Potential buyers will almost always want to see the last 3 years of tax returns. (see also # 9)

The level of interest rates in the U.S. economy have a direct impact on the value of a company determined by a professional valuation and have an indirect impact on the value of a company being sold. Business owners should include the interest rate outlook as one of the considerations in the timing of their exit from the business.

Direct Impact: In a professional valuation, the calculations to determine the value of the company use the current values for short- and long-term interest rates. The lower the interest rates, the higher the value of the business. With the current interest rate environment, valuations should be at their highest level for most companies.

Indirect Impact: Sellers should re-run our Valuation GURU after an interest rate change to see how much this change affects the value of the business and change their listing price. Investment bankers, many business brokers, and most potential buyers are going to recalculate their figures after the Federal Reserve changes its federal funds rate target. Over time, these economy-wide interest rate changes are factored into the prices that sellers are listing and the offers that buyers are making.

For valuation purposes, the valuation expert assumes that the company stays in the same corporate form that it is currently in, e.g., a partnership remains a partnership.

When a company is for sale, the price that the buyer is willing to pay depends upon whether the buyer can continue to receive the same tax advantages that the current owner receives. For example, a partnership for sale is worth more to another partnership or an S Corp than it would be to a C Corporation, all other factors being equal.

The tax pass thru advantage of sole proprietorships, LLCs, partnerships, and corporations filing taxes under subchapter S is an important dimension of the value of the company. The Valuation GURU separates the total value of these corporation types into the value from the tax pass thru and the value from business operations.

If their worst enemy is their biggest competitor, then that company may have the most to gain from buying the owner’s company. In effect, the biggest competitor may be the Strategic Buyer willing to pay the most.

As noted above, valuation is a science to estimate the value of a business if sold with no special circumstances. When an owner gets ready to sell the business, he/she needs to focus on identifying those companies that have special circumstances that would produce the greatest flow of earnings. It is up to the owner to get a piece of that greater future pie.

One of the most important steps in exit planning is to consider the possibilities for a Strategic Buyer. If the owner is successful in identifying one or more companies that should be willing to pay a premium for his/her company, then the owner does not need to engage a business broker to help sell the business.

Business brokers can take a substantial percentage of the sales price as their commission. While they offer to perform a variety of services for that commission, finding the right buyer is the most valuable. An owner can retain other experienced professionals to help in the negotiation, due diligence, and closing details, typically at far less than they would pay for these services as part of the broker’s bundled commission.

Your accountant has been great at finding legal ways to minimize the taxes you pay on the earnings of the business over the years.

However, when the business owner wants to sell the business, all the potential buyers want to review the past few years of tax returns.

There will likely be a disconnect between the sales price the owner wants based on the earnings as he/she sees from the business and what buyers are willing to pay for the much lower earnings they see reported on the tax returns.

The business owner that wants to sell the business needs to start preparing at least three years before to show higher earnings and to pay the taxes on those earnings. In most cases, the value payback when the business is sold will far outweigh the higher taxes in the interim.

Often, accountants are so focused on tax minimization that they do not advise owners to make the shift to value maximization. If so, find a new accountant that is experienced in business sales transactions.

Because of the many complexities in selling a business, business owners must evaluate whether their lawyer (and other advisors, including the accountant, financial advisor, and insurance agent) are sufficiently experienced in business sales transactions to ensure that the business owner gets the maximum value for his/her business. If you need coronary bypass surgery, you want an experienced surgical team and hospital that perform this type of surgery every day.

Selling a business is the biggest business life event of all. Business owners need to have an experienced team supporting them to make sure that everything goes as planned.

Ask your attorney about his/her experience with business sales transactions. Ask him/her to recommend a specialist that can be part of the team. If your attorney is not open to working with another attorney more experienced in business sales transactions, then you should find a new lawyer and get one that is experienced in business sales transactions.